The Evidence Still Favors Low Volatility ETFs

Right now, the good folks at Morningstar view low volatility ETFs as too expensive. The analysts at the investment evaluation giant believe that investors should focus on mega-cap brand name corporations instead -- companies that may have more reasonable prices relative to earnings and/or fair value estimates.

Mega-cap ETFs include assets like Guggenheim Russell Top 50 (NYSEARCA:XLG) as well as Vanguard Megacap (NYSEARCA:MGC). Both have performed admirably over the course of the last two years. On the other hand, low volatility funds like PowerShares S&P 500 Low Volatility (NYSEARCA:SPLV) and iShares Minimum Volatility (NYSEARCA:USMV) are capturing more in the way of capital appreciation as well as the investing public's imagination.

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It is true that low volatility funds are heavy on non-cyclical economic sectors like utilities, consumer staples and healthcare. It is also true that the current price-to-earnings ratio in the segments are higher than their respective historical norms. Yet this argument ignores a variety of other factors that influence the demand for certain types of assets, from quantitative easing to comparable yield spreads to declining economic growth to technical trends to asset volatility.

Perhaps ironically, Morningstar's Michael Rawson may have inadvertently thrown a bone to the "low vol" defense. In seeking to bolster Morningstar's case for mega-cap ETFs like XLG, the writer expressed that the Russell Top 50 Index was only modestly less volatile than the S&P 500. Its annualized return since 2002 was 3.2%, whereas the S&P 500 was 4.9%. Yet here's where the news gets even more impressive. The S&P 500 Low Volatility Index that SPLV is based on compounded at 8.6% -- and was roughly one-third as volatile as the Russell Top 50 Index that XLG tracks.

Before going any further, let's translate what this means, both financially and emotionally. An investor with $250,000 in the equivalent of the Russell Top 50 Index over the last 11 years experienced enormous price swings en route to $354,000. An investor with $250,000 in the equivalent of the S&P 500 Low Volatility Index over the last 11 years recorded $620,000, with a fraction of the roller coaster ride that has defined U.S. equities in the current century.

$620,000 vs. $354,000? One-third the risk? Why is it sensible to push funds like SPLV and USMV away from the portfolio table based on historical P/E or price to proprietary fair value alone?

Granted, the future is not going to be the same as past. Nevertheless, let me add yet another wrinkle: the bond market. If one looked at U.S. treasuries in a similar vacuum as Morningstar's one-track fundamental stock analysis, one could make a case that iShares 7-10 Year Treasury (NYSEARCA:IEF) is ripe for bearish losses of 30%. However, globally coordinated quantitative easing by central banks accompanied by a high demand for perceived safety keeps the 10-year from reverting to a mean historical yield of 4.75%.

My point is not to say that bond valuation and stock valuation involve the same process or metrics. Rather, neither asset type is likely to move on "book wormy" valuation alone. In fact, both non-cyclical heavy stock ETFs like SPLV and USMV as well as treasury bond ETFs like IEF owe larger-than-life inflows and exceptional price gains to a perception of safety as well as quantitative easing. In other words, "valuation shmowluation!"

By the way, I have nothing against mega-cap ETFs whatsoever. I feel as if ETFs like MGC and Vanguard Mega-Cap Growth (NYSEARCA:MGK) are worthy of buying on the next 8%-10% pullback. Nevertheless, for those portfolios that haven't benefited from equity income standouts like WisdomTree Equity Income (NYSEARCA:DHS) or SPLV in the past, your opportunity is coming. A 50-day trendline could serve as an entry point or you could wait for a 5%-6% sell-off.

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